

Capital BudgetingCapital Budgeting is the process by which the firm decides which longterm investments to make. Capital Budgeting projects, i.e., potential longterm investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:
A Capital Budgeting decision rule should satisfy the following criteria:
Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable.
ConceptsTools and Problems
© 2002  2010 by Mark A. Lane, Ph.D.
